Macroeconomics ECON 2301 May 2010 Marilyn Spencer, Ph.D. Professor of Economics Chapter 14

2nd Exam Tuesday, May 25 Expect it to be structured the same way as Exam 1.

Extra Credit Opportunity #7 Find out who won the Nobel Prize for Economics – announced Monday, Oct. 12. Find out what research strand(s) the prize is recognizing. Send me that info in an email, before class Wednesday, May 26. 4 points possible

Extra Credit Opportunity #8 View the film, “Soylent Green.” Find out that economy’s solution to its “social security problem.” Send me a summary in an email, before class Wednesday, May 26. 4 points possible

Chapter 14: Deficit Spending and the Public Debt

Learning Objectives: Explain how federal government budget deficits occur Define the public debt and understand alternative measures of the public debt Evaluate circumstances under which the public debt could be a burden to future generations Discuss why the federal budget deficit might be measured incorrectly Analyze the macroeconomic effects of government budget deficits Describe possible ways to reduce the government budget deficit

Did You Know That... The U.S. federal government spends a total of more than $3 billion per day on Social Security, Medicare, and Medicaid. Each of these guaranteed spending programs is individually nearly as large as the entire discretionary portion of the federal government’s budget.

Public Deficits and Debts: Flows versus Stocks Government Budget Deficit: situation in which the government spends more than it receives in taxes during a given period of time Is financed by the selling of government securities (bonds)

Public Deficits and Debts: Flows versus Stocks (cont'd) The federal deficit is a flow variable, one defined for a specific period of time, usually one year. If spending equals receipts, the budget is balanced. If receipts exceed spending, the government is running a budget surplus.

Public Deficits and Debts: Flows versus Stocks (cont'd) Balanced Budget: situation in which the government’s spending is exactly equal to the total taxes and revenues it collects during a given period of time Government Budget Surplus: excess of government revenues over government spending during a given period of time

Public Deficits and Debts: Flows versus Stocks (cont'd) Public Debt: total value of all outstanding government securities A stock variable

Government Finance: Spending More than Tax Collections Since 1940, the U.S. federal government has operated with a budget surplus in 13 years. In all other years, the shortfall of tax revenues below expenditures has been financed with borrowing.

Figure 14-1 Federal Budget Deficits and Surpluses Since 1940

Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP

Policy Example: Explaining a $109 Billion Deficit Projection Turnaround Why was the government’s 2005 deficit projection off by $109 billion? Federal tax revenues turned out to be more than 15% higher in 2005. Economic growth caused taxable incomes, hence revenues, to be much higher than anticipated.

Evaluating the Rising Public Debt Gross Public Debt: All federal government debt irrespective of who owns it Net Public Debt: Gross public debt minus all government interagency borrowing

Evaluating the Rising Public Debt (cont'd) Some government bonds are held by government agencies. In this case, the funds are owed from one branch of the federal government to another. To arrive at the net public debt, we subtract interagency borrowings from the gross public debt.

Evaluating the Rising Public Debt (cont'd) Tax revenues tend to be stagnant during times of slow economic growth. Tax revenues grow more quickly when overall growth enhances incomes. As long as spending exceeds revenues, the budget deficit will persist.

Table 14-1 The Federal Deficit, Our Public Debt, and the Interest We Pay on It

Figure 14-3 Net U.S. Public Debt as a Percentage of GDP

Net U.S. Public Debt as a Percentage of GDP During World War II, the net public debt grew dramatically. After the war It fell until the 1970s Started rising in the 1980s Declined once more in the 1990s And recently has been increasing again

Evaluating the Rising Public Debt (cont'd) The government must pay interest on the public debt outstanding. The level of these payments depends on the market interest rate. Interest payments as a percentage of GDP are likely to rise in the future.

Evaluating the Rising Public Debt (cont'd) As more of the public debt is held by foreigners, the amount of interest to be paid outside the United States increases. Foreign residents, businesses and governments hold nearly 50% of the net public debt. Thus, we do not owe the debt just to ourselves.

Evaluating the Rising Public Debt (cont'd) If deficits lead to slower growth rates future generations will be poorer. Both present and future generations will be economically better off if… Government expenditures are really investments The rate of return on such public investments exceeds the interest rate paid on the bonds

Evaluating the Rising Public Debt (cont'd) If the economy is already at full employment, then further provision of government goods will crowd out some private goods. Deficit spending may raise interest rates, which in turn will discourage capital formation in the private sector.

Evaluating the Rising Public Debt (cont'd) Crowding-out may place a burden on future generations. Increased present consumption may crowd out investment and reduce the growth of capital goods, which could reduce a future generation’s wealth. Taxes may have to be increased, imposing higher taxes on future generations in order to retire the debt.

Evaluating the Rising Public Debt (cont'd) Paying off the public debt in the future If the debt becomes larger, each person’s share would increase. Taxes would be levied, and may not be assessed equally. A special tax could be levied based on a person’s ability to pay.

Evaluating the Rising Public Debt (cont'd) Our debt to foreign residents We do not owe all the debt to ourselves. Future U.S. residents will be taxed to repay principal and interest. Portions of U.S. incomes will be transferred abroad.

Evaluating the Rising Public Debt (cont'd) If deficits lead to slower growth rates future generations will be poorer. Both present and future generations will be economically better off if… Government expenditures are really investments The rate of return on such public investments exceeds the interest rate paid on the bonds

International Example: Where Are Most Treasury Securities Held Abroad? More than $2 trillion in U.S. Treasury securities of the $5 trillion in net outstanding debt is held outside the United States. Japan accounts for more than one-third of all foreign holdings of the U.S. net public debt.

Figure 14-4 The Distribution of Foreign Holdings of U. S Figure 14-4 The Distribution of Foreign Holdings of U.S. Treasury Securities

For critical analysis: International Example: Where Are Most Treasury Securities Held Abroad? (cont'd) For critical analysis: Why might the fact that market interest rates in Japan have hovered very close to 0% during the 2000s help explain relatively large holdings of U.S. Treasury securities by residents of that country?

Federal Budget Deficits in an Open Economy Question: Is there a connection between the U.S. trade deficit and the federal government budget deficit? A trade deficit exists when the value of imports exceeds the value of exports. Some say it appears that there is a relationship between trade and budget deficits; at least there is a statistical correlation between the two.

Figure 14-5 The Related U.S. Deficits Sources: Economic Report of the President; Economic Indicators, various issues; author’s estimates.

Federal Budget Deficits in an Open Economy (cont'd) If foreigners are using the dollars they hold to buy U.S. government bonds, then they will have fewer dollars to spend on U.S. exports. This means that a U.S. budget deficit can contribute to a trade deficit.

Growing U. S. Government Deficits: Implications for U. S Growing U.S. Government Deficits: Implications for U.S. Economic Performance Which government deficit is the true deficit? The government may report distorted measures of its own budget. Government has not adopted a business-like approach to tracking its expenditures and receipts. Official government “measures” yield lowest possible deficits and highest reported surpluses.

Growing U. S. Government Deficits: Implications for U. S Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) An operating budget includes current outlays for on-going expenses, such as salaries and interest payments. A capital budget, includes expenditures on investment items, such as machines, buildings, roads and dams.

Growing U. S. Government Deficits: Implications for U. S Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Question How do higher deficits affect the economy in the short run? Answers: If the economy is below full-employment, the deficit can close the recessionary gap. If the economy is already at full-employment, the deficit can create an inflationary gap.

Growing U. S. Government Deficits: Implications for U. S Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) In the long run, higher government budget deficits have no effect on equilibrium real GDP. Ultimately, spending in excess of receipts redistributes a larger share of real GDP to government-provided goods and services.

Growing U. S. Government Deficits: Implications for U. S Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Thus, if the government operates with higher deficits over an extended period: The ultimate result is a shrinkage in the share of privately produced goods and services By continually spending more than it collects, the government takes up a larger portion of economic activity.

Growing U. S. Government Deficits: Implications for U. S Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) How could the government reduce all its red ink? Increasing taxes for everyone Taxing only the rich Reducing expenditures Whittling away at entitlements

Policy Example: How Rich Taxpayers Avoid Part of a Tax-Rate Increase Some estimates show increasing the top bracket from 35% to 39.6% would reduce total taxable income by at least 4%. Such projections show this increase as giving the highest income taxpayers a greater incentive to incorporate and pay lower corporate-profit tax rates. Thus, raising the income tax rate by 4.6% would result in less than a 4.6% increase in government tax collections – but an increase, not a decrease, as some suggest.

Growing U. S. Government Deficits: Implications for U. S Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) In considering how expenditures might be reduced, it is important to look at entitlements, the federal government payments that are legislated obligations and cannot be reduced or eliminated. What are some of these entitlements?

Growing U. S. Government Deficits: Implications for U. S Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Entitlements: Guaranteed benefits under a government program such as Social Security, Medicare, or Medicaid Non-controllable Expenditures: Government spending that changes automatically without action by Congress

Figure 14-5 Components of Federal Expenditures as Percentages of Total Federal Spending Source: Office of Management and Budget.

Growing U. S. Government Deficits: Implications for U. S Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Entitlements are the largest component of the U.S. federal budget. To make a significant cut in expenditures, entitlement programs would have to be revised.

Growing U. S. Government Deficits: Implications for U. S Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Question What are the political costs of reducing entitlement payments for Social Security, Medicare, and Medicaid???

Summary of Learning Objectives Federal government budget deficits Whenever the flow of government expenditures exceeds the flow of government revenues a budget deficit occurs. The public debt Total value of all government bonds outstanding The federal budget deficit is a flow, whereas accumulated deficits are a stock, called the public debt.

Summary of Learning Objectives(cont'd) How the public debt might prove a burden to future generations Higher taxes will reduce private consumption. Crowding out might reduce economic growth. Why the federal budget deficit might be incorrectly measured No distinction between capital expenses and operating expenses Each estimate is based on a set of assumptions.

Summary of Learning Objectives (cont'd) The macroeconomic effects of government budget deficits Because higher government deficits are caused by increased government spending or tax cuts, they contribute to a short-run rise in total planned expenditures and aggregate demand. In the long run, increased deficits only redistribute resources from the private sector to the public sector.

Summary of Learning Objectives (cont'd) Possible ways to reduce the government budget deficit: Increase taxes Reduce expenditures by revising the terms of entitlement programs

Assignment to be completed before class May 25: Study for Exam 2! Pre-read Chapter 15 & these end-of-chapter Problems: 14th ed: 15-2, 15-4, 15-6, 15-8, 15-13, 15-14 & 15-15, on pp. 389-391; 15th ed: 15-2, 15-4, 15-6, 15-8, 15-13, 15-14 & 15-15, pp. 391-393. Pre-read Chapter 16 & these end-of-chapter Problems: 14th ed: 16-1, 16-2, 16-4, 16-7, 16-9, 16-12 & 16-15, on pp. 420-421; 15th ed: 16-1, 16-2, 16-4, 16-7, 16-9, 16-10 & 16-13, on pp. 420-421.